United States

Nonprofit corporate governance - Directors’ fiduciary responsibilities

MUSE  | 

One of the long-term effects of the Sarbanes-Oxley Act (SOX) has been to renew focus on effective corporate governance. Although the for-profit sector was the original target of SOX, it did not take long for the nonprofit sector also to come under fresh scrutiny, both by regulators and business groups who have used the opportunity to revise and enhance the key concepts of corporate governance. Consequently, we've seen a number of refinements to governance guidelines in recent years, as seen in such papers as Guide to Nonprofit Corporate Governance by the ABA Coordinating Committee on Nonprofit Governance, and Principles for Good Governance and Ethical Practice: Guide for Charities and Foundations by The Panel on the Nonprofit Sector, and, in the case of the IRS, a list of recommended governance policies for tax-exempt organizations, Governance and Related Topics - 501(c)(3) Organizations.

Best practices for nonprofit corporate governance have continued to evolve over the years in response to the changing business and regulatory environment. The overarching trend seems to be to increase transparency and accountability of nonprofit organizations and to more clearly articulate what directors must do to achieve those ends. The increasing size, diversity and complexity of the nonprofit sector, as well as other changes in compliance requirements, have also prompted renewed examination of the fiduciary responsibilities of officers, directors and trustees of nonprofit organizations. 

It's also worth noting that more is at stake than just legal and regulatory issues. Directors undergo constant scrutiny by their members, patrons, media, employees, fellow directors and the general public to ensure that the organization is meeting its goals and using donations properly. And of course, would-be whistle-blowers are also watching. For all of these reasons, as well as the serious consequences for both individual directors and the organization for violations of their fiduciary responsibilities, it's important to periodically review the basic concepts of effective corporate governance.  

Basis for the guidelines

Nonprofit corporate governance concepts are derived from a number of sources: IRS laws and guidelines, state statutes governing nonprofit corporations, case law and industry standards. While state statutes do provide a general regulatory scheme to which directors must adhere, much of the authority over this area comes in the form of industry guidance and best practices. In terms of federal tax laws, the IRS recognizes that governance practices will vary based on the size, complexity and mission of different organizations. The IRS, therefore, views its role as one of providing guidance rather than one of enforcement per se; its goal is not to tell an organization how to govern, but to allow the organization to decide for itself which governance practices are appropriate. As stated in IRS Governance and Related Topics - 501(c)(3) Organizations,
"…while the tax law generally does not mandate particular management structures, operational policies, or administrative practices, it is important that each charity be thoughtful about the governance practices that are most appropriate for that charity in assuring sound operations and compliance with the tax law." 

Basic fiduciary duties of board directors

From the Model Nonprofit Corporation Act and various state laws, here's a brief overview of the oversight duties of directors of nonprofit organizations.

  • Duty of care
  • Duty of loyalty
  • Duty of obedience to purpose
Duty of care
  • The duty of care requires that each member of the board of directors shall act in good faith and in a manner the director reasonably believes to be in the best interests of the nonprofit organization. Board members must discharge their duties with the care that persons in a like position would reasonably believe appropriate under similar circumstances.
  • Each member must be informed and exercise independent business judgment.
    • Must attend meetings
    • Must make reasonable inquiries
  • May rely on information and reports received from trustworthy sources
  • May delegate day-to-day operations to management
  • May rely on the business judgment rule if applicable
  • Considerations in fulfilling obligations:
    • Limited time will probably be a concern
    • Schedule of meetings
    • Information supply
    • Procedural rules
    • Industry specific legal requirements
Duty of loyalty
  • The duty of loyalty requires directors to exercise their powers in the interest of the corporation and not in their own interest or the interest of another entity or person.
  • Three key concepts
  • Conflicts of interest
  • Corporate opportunity
  • Confidentiality

Duty of loyalty - conflicts of interest

  • Directors must be conscious of the potential for conflicts and act with candor and care in dealing with such situations.
  • A conflict arises whenever a director has a material personal interest in a proposed contract or transaction to which the corporation may be a party.
  • A conflict is not inherently illegal.
  • A Conflicts of Interest Policy should exist to do the following:
    • Promote honesty among board members
    • Protect corporate decisions
    • Disclose potential conflicts
    • Disclose financial relationships
    • Disclose situations involving dualities or divided loyalty
  • Implementation of the Conflicts of Interest Policy should consist of the following:
    • It should be signed by each of the directors as well as any officers or employees who are in a position of control.
    • Each material conflict disclosed should be in writing and fully recorded in the minutes.
    • Duty exits even if transaction is fair.
    • Disclosure should include the existence and nature of the conflict and should be made before any action is taken with respect to the transaction.
    • It may be prudent for the conflicted director to be excused from that part of the meeting when the matter is being discussed or if his or her input is necessary for the discussion, from the vote.

Duty of loyalty - corporate opportunity

  • Directors have a duty to avoid appropriation of organizational assets or opportunities.
    • This issue arises when a director contemplates participating in a transaction which would plausibly fall with the organization's present or future activities.
    • Before engaging in the transaction, the director should disclose the transaction to the board in sufficient detail and with adequate time to enable the board to act or decline to act with regard to the transaction.

Duty of loyalty - confidentiality

  • In the normal course of business, directors should treat as confidential all matters involving the organization until there has been general public disclosure or unless the information is a matter of public record or common knowledge.  
Duty of obedience to purpose
  • Directors should be faithful to the underlying charitable purposes and goals of the organization.
Basic responsibilities of directors
  • Establish objectives and strategies
  • Ensure executive management is performing, including selection, promotion and compensation of executives
  • Monitor organization's financial well-being

Directors should:

  • Attend and participate in board meetings
  • Diligently read, review and inquire about corporate material
  • Monitor affairs and finances of the organization
  • Exercise independent judgment
  • Be fully engaged
  • Have a duty to inquire.
  • Duty exists when suspicions are or should be aroused.
  • "Shirking" is not a defense.
  • Directors are liable for neglect and ignorance of corporate affairs.
  • Inexperience is an ineffective defense.

Recommendations

  • Organizations should adopt corporate governance policies and procedures designed to enhance the board's exercise of its basic oversight functions.
  • Directors should become involved with senior executives' review of the organization's compliance plan.
  • Regarding the identification and recruitment of directors:
    • The IRS advises organizations to actively recruit those whose commitment, skills, life experience, background, perspective and other characteristics will serve the organization and its needs.
    • When recruiting directors, organizations should focus on areas of expertise in areas such as:
      • Finance, financial management, and investments
      • Personnel and human resources
      • Public relations and marketing
      • Governance and leadership
      • Legal and advocacy
  • Board service should be based on objective criteria, such as:
    • Meeting attendance (basis for automatic or discretionary removal)
    • Committee membership and attendance
    • Preparation for, and active participation at, board and committee meetings
    • Participation in board education
  • Organizations should aim to reduce the liability profile of individual directors and trustees via:
    • Attendance policies
    • Clear information in advance
    • Directors and officers liability insurance
  • Strengthen education and training of directors via:
    • Board orientation and training
    • A systematic educational process that insures they:
      • Are aware of legal and ethical responsibilities
      • Are knowledgeable about the organization's programs and activities
      • Can carry out their oversight responsibilities
    • Annual board retreats
    • Seminars (e.g., Governance Institute in the health care sector, consultants, audit and legal advisors)
    • Periodic reviews
    • Use of experts
    • Distribution of articles
    • Plain English disclosures

For more information

Submitted with permission by Tiffany Forte of Drinker Biddle & Reath, LLP. For more information on the directors' fiduciary responsibilities in your organization, please contact James Sweeney, partner, RSM US LLP at 239.810.2975.